Too Little of a Bad Thing?

After years of turbulence, equities markets are experiencing a period of relative tranquility. Some experts fear this calm surface could be masking trouble, but is there evidence to validate their concerns?

Stock market volatility entered its current state of stability in 2011, with the Volatility Index (VIX)—also known as the “fear index,” which measures investors’ volatility expectations by tracking the prices of futures contracts—falling to pre-recession levels. On its face, the present trend could be troubling. Historically, recessions have followed periods of low volatility, and the current slump in the VIX mirrors conditions in the mid-90s and mid-2000s, when complacent investors failed to see the risk posed by emerging asset bubbles.

The VIX’s history, however, could actually be a good sign that we’re finally on the path to real economic recovery. Given the cyclical nature of the market, the same periods of calm that preceded recessions have also tended to follow recessions during recovery periods. In the past, volatility has been a poor indicator of complacency—for instance in the late ‘90s, investors inflated the dot-com bubble, but their complacency was not reflected in the VIX, which rose sharply in the years prior to the 2000 crash.

Some investors also worry that monetary policies could be artificially suppressing volatility. Their central concern is that the Fed’s unorthodox asset-purchasing program, aimed at stabilizing the bond market, created an overconfidence among investors that the central bank will continue to cushion future shocks, which could be contributing to an inadvertent asset bubble. If the Fed’s asset-purchasing program led to complacency, the VIX should have spiked following last summer’s announcement that the fed would end the program. But it had little impact on volatility, indicating that investors’ calmness has little to do with monetary policies.

Another common fear experts have regarding low volatility is that investors may be ignoring the Fed’s looming interest rate hike. In the past, rising interest rates have accompanied market volatility—but the correlation is strongest when rates are already relatively high and fluctuating rapidly. The current outlook calls for interest rates to climb steadily over a period of years, and even with increases, many expect rates to remain below historic levels. Ultimately, it’s likely that investors aren’t ignoring interest rate expectations—they’re reacting to them.

Today’s low volatility may actually reflect consensus, not complacency, among investors. With significant room for growth remaining in the global economy, most believe inflation will remain low and growth will continue. In light of the previous recession, it’s understandable that some are nervous over the widespread optimism, but we should equally consider the possibility that volatility is low because there is little left to fear.

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